Tuesday, December 8, 2009

Rating woes

Over the past 24 hours there have been several news with respect to sovereign ratings. S&P put Greece's A- rating on creditwatch negative and revised the outlook for Portugal to negative from stable. S&P stated that Greece's rating may be affirmed if the government's strategy is aggressive enough to secure a significant and sustained decline in the public debt burden, otherwise the rating could be cut a step to BBB+. This step has been a bit of a surprise given that S&P's rating for Greece is already two steps below the Moody's rating for Greece of A1 (Fitch cut Greece to A- in October). However, from my perspective it is well warranted by the structural challenges facing the economy on the one side and the lack of precedents in the recent Greek history to deal with any of those even during good times (most notably the fiscal deficit). One should not forget that the Greek economy has been used to relatively high levels of nominal growth and a comparatively low level of nominal yields, rendering debt service (not only for the governnment) a minor problem. However, the period of substantial nominal growth is likely to be past for at least several years whereas especially real interest rates are likely to be substantially higher than over the last decade. In turn, the servicing of the outstanding debt will become a larger problem in the future and clearly there is no easy way out of this.I have frequently mentioned that I see Ireland, Portugal and Spain having similar problems to Greece. In turn, I expect more negative rating actions on any of these sovereigns over the upcoming year. So far, I have not seen any steps which convince me that the challenges (low competitivity, high indebtdedness, higher real interest rates/rising debt service burden in real terms) have been fully understood and the will is there to remedy the situation on the sovereign as well as the corporate side. Therefore, despite the wide levels of spreads I maintain my underweight view in all of these sovereigns. I also reiterate that I remain less worried with respect to Italy and expect the 10y spread between Italian and Spanish government bonds to narrow to single-digit levels over the course of next year from the current 20bp area.

Unrelated to that, Moody's published its latest AAA Sovereign Monitor which mostly focused on the four largest AAA-rated countries - France, Germany, the US and the UK - out of the eight AAAs. FT Alphaville has the following chart (found here). The expected development especially of the UK and the US look worrisome.

Source: Moody's

With respect to the UK, Moody's cites that the "the UK government exhibits a high degree of debt reversibility" which is "supported by the trend over recent months towards an apparent consensus among the public that fiscal retrenchment (including cuts in expenditure) is both inevitable and desirable." However, Moody's also warns: "While assumed capacity for fiscal adjustment currently supports the maintenance of the Aaa rating of the UK government, this assumption will have to be validated by actions in the not-too-distant future to continue to provide support for the rating." In turn, if following the election the government does not take action to reduce the structural budget deficit, then we should expect Moody's to become much more outspoken with respect to the UK's AAA rating.

Looking at the US, Moody's states: "... it is clearly necessary to bring the defict down to a sustainable level to avoid an unsustainable upward trajectory in debt ratios in the future. Administration officials have said that the next budget, which will be presented in February 2010, will include measures to reduce the deficit to a lower level in order to prevent debt from reaching the levels implied by the current projections. A credible fiscal consolidation strategy would reduce the risk of higher interest rates and therefore a major deterioration in debt affordability that could come from a decline in confidence in financial markets." Therefore, it is likely that Moody's will step up its language should the next budget not show a will to reduce the longer-term deficit.Overall, a negative rating action on the UK and even more so on the US is a much larger challenge for any of the rating agencies than downgrading say Greece. In turn, it needs a long preparation by the rating agencies and I would not bet on negative rating actions to take place soon. Rather the language will become tougher several times before we a negative outlook can be rewarded. I personally think that the US will not see a negative rating action but that the UK will suffer from at least a negative outlook (if following the elections no significant actions are taken that could be the case already before the end of 2010). My views with respect to the UK remain unaltered and I look for a prolonged period of economic underperformance which will be mirrored in the development of financial assets. Furthermore, I also continue to see the highest risk of an inflationary outcome amongst the major economies for the UK.

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About Me

Daniel was Head of Economics & Strategy for developed markets at Dresdner Kleinwort until early 2009 and was responsible for the well-known 'Ahead of the Curve' flagship publication. He started as a Desk Analyst in the mid-90s for the former German government bond trading desk. He then became Head of Rates Strategy early last decade and later on also took responsibility for G10 economics, commodities strategy and asset allocation.
He is now the owner of Research Ahead GmbH located in Frankfurt am Main.

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